The Engine of Prosperity

After a spectacular run-up in stock prices in 2013 (with the S&P 500 Index delivering a total return of 32.4 percent for the year), the natural question on the lips of many is, Can it continue?

Alas, there is no simple answer. By some measures the U.S. stock market continues to look attractive. And, then, what are the other options? With bond yields low — and expected to increase — there seem to be no guarantees in fixed income securities. Overseas, the news is of slowing growth in China, endemic corruption in India and a kleptocracy in Russia intent on a land grab in the Ukraine. If these are the alternatives, a U.S. investor may be forgiven for sticking close to home

While I do not foresee a crash on par with the 2008 debacle, I fear corporate treasurers may be running out of options. For a non-financial company (read, not a bank) whose stock is publicly traded, there are three levers to arrange to make the firm’s stock relatively more attractive.

The first is leverage. This works as long as the interest rate paid on the debt issued is below the return on the marginal investment. With interest rates at record lows firms have reaped a bounty on this spread. The second is to sweat assets (and, their labor force). Firms have displayed startlingly ingenuity in passing off costs to their suppliers and demanding more effort for less reward from their employees. The problem is the workers are becoming restive and their suppliers are pushing back. And, the third avenue, is to buy back shares and raise dividend payments. Check and check again. Indeed, firms have been leveraging up not so much to finance new factories and facilities, but, rather to repurchase their shares.

At some point, individually and in the aggregate, firms will exceed the tipping point with way more debt capital than is prudent. This is reflected in the steady, secular decline in the number of companies sporting a AAA credit rating. Today only four firms continue to make it a point to maintain a sterling debt rating.

Hence the reason why the markets are consumed with revenue growth. Companies have demonstrated they can cut, cut again, and then cut some more. Few in contrast have demonstrated a knack for consistently raising revenues to grow earnings.

In the end, one firm’s expense is another company’s revenue. And, the compensation line on an income statement reflects the salaries of the economy’s end consumers.  If there is a present danger, it is not an inflationary surge, but a deflationary spiral if corporations persist in destroying demand.

Click here to read the commentary, 20140502 The Engine of Prosperity